Downgrades Have Impact, Brighter Outlook Ahead

After a yearlong dry spell, observers of the high yield bond market are predicting a slow and steady upturn within the next three to six months.

"A year ago there was lots of money to be made, and then there was lots of money to be lost. Right now I'd be cautiously optimistic. There's still an appetite for junk and risk out there," said Kamalesh Rao, an economist with Moody's Investors Service. "It probably won't match the second quarter of '98, but it looks like things have bottomed out."

Modest signs of recovery are already visible. The ratio of downgrades to upgrades is up and commodity prices are rising. Oil, at $10 a barrel in April, is now at $22 a barrel. Also, according to Rao, interest rates have stabilized since the last Federal Reserve rate hike, leading investors to expect a surge of both investment-grade and junk issuances in the fall.

According to Eric Stephenson, a director at Fitch IBCA, a fairly benign inflation rate and continued real growth in GDP as the economy enters its 101st month of expansion will stabilize the high yield market. Investors, recovering from an underwriting frenzy that nearly crippled the market in late 1997 and early 1998, are becoming more rational and exerting discipline on the market.

"I think stability is the tone of the market," said Margaret Patel of Pioneer Investment Management Inc. "Industry selection is going to be an important factor in performance. It will be important to concentrate on stable industries or those growing at a faster rate than the economy," she said.

Late last summer, after Russia defaulted on its sovereign debt, it set into motion a downturn in what some called a hyper-inflated high yield market, already plagued by an abundance of poor-quality issuers. While the currency crisis rolled through Asia into Russia and Latin America, commodity producers in these countries faced collapsed demand for their products at home and depressed prices abroad.

As foreign commodity producers tried to beef up their exports, they created a supply-demand imbalance, pushing commodity prices even lower and cutting into producers' cash flows. Already highly-leveraged domestic producers couldn't make payments on outstanding debt, sending many high yield issuers into default.

Coupled with evidence that many low-rated issuers, especially in the telecommunications and shipping industries, were facing liquidity problems, investors became immediately skittish.

The second half of 1998 showed a definite increase in the ratio of downgrades to upgrades compared with the same period the year before - a trend that is only beginning to slow down.

During the first half of this year, Moody's downgraded 91 companies worth $25.5 billion in debt.

"Downgrades are far outpacing upgrades at this point despite the upward movement of the economy. Defaults have increased significantly both in dollar amount and in volume," said Diane Vazza, a director in Standard and Poor's private development group.

Commodity producers, including metals, paper, and chemical makers, and telecommunications companies were among the biggest losers in this downswing. In January alone, three steel companies were downgraded by Moody's: Geneva Steel Co. dropped from Caa1 to Ca; Gulf States Steel, Inc. dropped from B3 to Caa3; and Northwestern Steel and Wire Co. fell from B3 to Caa1. Iridium LLC, a satellite telecommunications firm, plummeted from B3 to Caa3 in mid-May.

"The default rate is an effect of who issued bonds in the first place. If the market hadn't been so accommodating, so many of them would never have come to market trading. There was a high yield spread of 350 basis points in 1997 - it was a very receptive market and it took about one year for these companies to get into trouble," said Patel.

But, as evidence to the brighter outlook for the coming months, even the downgrade situation appears to be improving.

In the first three months of 1999, Moody's Investors Service downgraded 74 companies with $20.1 billion in debt, while upgrading 27 companies with $15.0 billion in debt. While another 84 companies were downgraded by Moody's in the second quarter of this year with a total value of $23.1 billion in debt, there was a significant increase in the number of upgrades - 38 companies with a total if $17.5 billion in outstanding debt.